Take Cover With Overlay Strategies

Written by Bruce Geddes on Monday, September 27th, 2010 at 3:51 pm

Increasingly, plan sponsors and consultants view interest rate risk, relative to plan liabilities, as uncompensated. However, many plans are underfunded and thus reluctant to further increase fixed income allocations at the expense of other asset classes, thereby leaving exposure to long-term interest rates unhedged.

Employing derivatives-based overlay solutions to increase the interest rate matching characteristics of the assets (to the liabilities) offers an alternative to increasing allocations of physical capital to fixed income strategies. Interest rate overlay solutions may be designed to replicate the term structure characteristics of a plan’s liability cash flows and overall interest rate sensitivity, by “leveraging up” interest rate exposure to create a longer asset duration profile. Achieving the incremental interest rate exposure through the overlay means that an explicit allocation of capital is not required, and does result in a financing requirement.

Typically, an interest rate overlay provides the investor with long-term fixed rates of interest, financed by variable short-term rates of interest. With an overlay strategy, the nature of the plan’s interest rate risk moves from long-term fixed rate debt to floating rate debt, which is relatively more attractive for pension fund investors given the current accounting and regulatory framework. In the current interest rate environment, the low level of short-term financing costs, combined with the extra yield pickup provided by a steep yield curve, has some investors attracted to the strategy by the “carry” that is available.

While overlay strategies have their merits, investors should proceed with caution and ensure that they have the correct governance and risk mitigation structures in place before implementing an overlay program. Beyond the risks that exist in investing in long-term interest rate exposures in general, there are risks unique to the use of derivatives and leverage that will come with this approach, including counterparty, liquidity, capital adequacy and operations.

For example, given the nature of the derivatives used, an overlay program can be heavily reliant not only on the ability of counterparties to honour their contractual payment obligations, but their willingness to make the facilities continually available to support the programs as well. In Canada, this is particularly relevant due to the fact that the interest rate derivatives market is largely an over-the-counter market dominated by few counterparties. Should such strategies become widely adopted by Canadian plans, systemic leverage, combined with market disruption, may lead to an unwillingness of these counterparties to extend financing. Without this, the plan may be unable to implement the investment objective of the overlay.

Another cautionary consideration is that, as appealing as these structures may be from an increased interest rate hedge context, some investors may, with the capital freed up through the leveraged overlay strategy, and in the quest for incremental returns, assume too much overall risk by maintaining or even augmenting their allocation to risky assets.

For these reasons, an established and well-communicated governance structure as well as a sound understanding of both the benefits and the risks is critical. It is recommended that plan sponsors work closely with service providers to determine the appropriateness of overlay strategies within their overall asset/liability profile.

In summary, interest rate overlay strategies may be an effective approach to improving the management of the interest rate sensitivity of a plan’s liability exposures. While not for every plan, they are worthy of exploration by sponsors who take the time to understand and become comfortable with the risks inherent in such strategies.